Iceland Crises

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Business Administration (BScB) + (IM)

Authors: Ellert Jón Björnsson Kristinn Thor Valtýsson Advisor: Roger Bandick

Financial Crisis in Iceland
Icelandic Monetary Policy

Aarhus School of Business December 2009

Abstract
From being one of the poorest nations in Europe to becoming one of the most successful economies in the West, the geographically isolated country of Iceland suffered a lot when its three major banks collapsed in the same week in October 2008. As a consequence of the banking crisis, Iceland entered a deep recession and deep cuts in employment were made and the exchange rate dropped sharply which caused the inflation to soar. The Central Bank of Iceland has been criticized for its monetary policy in the past and how it handled the collapse. This thesis is intended to examine the monetary policy in Iceland and how the Central Bank handled the collapse and to look into the causes that made the financial crisis to be so severe.

Keywords: Iceland, Financial Crisis, Monetary Policy, Central Bank, Inflation.

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Table of Contents
1.0 Introduction .............................................................................................................. 6 2.0 Theoretical Framework ............................................................................................ 8 2.1 Quantity Theory of Money .................................................................................. 9 2.2 IS-LM Relation .................................................................................................. 10 2.3 AS-AD Relation ................................................................................................. 12 2.4 Extension of IS-LM Relation ............................................................................. 14 2.5 Phillips Curve..................................................................................................... 15 2.6 Marshall-Lerner Condition - Interest Parity Condition ..................................... 17 2.7 Net Capital Outflow ........................................................................................... 18 2.8 Exchange Rate ................................................................................................... 20 3.0 Central Bank‟s Actions and Policies...................................................................... 21 3.1 Importance of the Independence of the Central Bank ....................................... 21 3.2 Policy Instruments ............................................................................................. 22 3.2.1 Open Market Operations ............................................................................. 23 3.2.2 Interest Rate ................................................................................................ 23 3.2.3 Reserve Requirements ................................................................................ 24 3.2.4 Foreign Exchange Market Intervention ...................................................... 25 3.3 Goals of the Central Bank .................................................................................. 25 3.4 Inflation .............................................................................................................. 26 3.5 Exchange Rate ................................................................................................... 27 3.5.1 Balance of payments ................................................................................... 28 3.6 Monetary Tools in Action .................................................................................. 29 4.0 The Objectives and Roles of the Central Bank of Iceland ..................................... 30 4.1 Interest Rate ....................................................................................................... 31 4.2 Inflation in Iceland ............................................................................................. 31 4.3 Relation Between...
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